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Lending Covenants

Introduction

Lending covenants are a key component in all lending agreements and are often as important to borrowers as credit pricing, sometimes more so. They define the terms under which companies can access credit.

As a result of the financial crisis and weak economy banks have tightened lending covenants and margining requirements for 2009 and 2010 renewals. Typically the number and severity of restrictions in a bank covenant package increases in direct proportion to how a bank assesses a borrower’s industry from a risk viewpoint and the company’s financial condition.

Lending Covenants

Banks use lending covenants to manage lending risk. Covenants define borrower performance requirements and, in the event of default, accelerate the maturity of a bank loan.

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Covenants fall into two broad categories:
  1. Affirmative covenants require borrowers to perform certain acts such as discharging contractual obligations (e.g. pay bank interest and fees, remit taxes, etc.) and providing financial information on certain dates (monthly accounts receivable listings, quarterly financial statements, etc.). Affirmative covenants are fairly standard and are often referred to as the agreement’s boilerplate provisions.
  2. Negative covenants prohibit borrowers from actions that might be prejudicial to the lending bank. Examples include covenants that limit capital expenditures or dividend payments. Negative covenants can either be maintenance covenants (the lender must meet covenant requirements like financial reporting on a regular basis) or incurrence covenants (the lender must satisfy a requirement like minimum net worth before a dividend declaration is permitted)

There are nine classes of bank lending covenants:

  1. Operating Activity

These covenants constrain a firm’s day-to-day operating activities (e.g. must pay taxes, can’t change business location without prior permission, restrictions on transactions with subsidiaries and affiliates, etc.)

  1. Investment Expenditure

These covenants restrict a firm’s ability to make capital expenditures, acquisitions, employee loans, or other major cash outlays.

  1. Asset Sale

These covenants limit the ability of a firm to sell assets during the normal course of business and typically include a materiality provision.

  1. Cash Payout

These covenants limit the ability of a firm to pay dividends, redeem stock, pay down debt, pay management fees, etc.

  1. Financing

These covenants control the amount of debt or lease contracts that a company can assume.

  1. Reporting & Disclosure

These covenants specify requirements for the dissemination of borrower information (furnish financial statements, provide proof of covenant compliance, present budgets and forecasts, notification of litigation, etc).

  1. Collateral Preservation

These covenants restrict debt guarantees, require the purchase of insurance, limit liens, require the maintenance of collateral value, etc

  1. Ownership

These covenants provide for continuity in a firm’s corporate governance structure (e.g. restrictions on management or board changes, changes in control, etc.)

  1. Financial Performance

These covenants define financial performance requirements and are based on financial thresholds or ratio limits.  Covenant types include:

  • Liquidity covenants (minimum working capital, current ratio, etc.)
  • Equity covenants (net worth, tangible net worth, etc.)
  • Debt and leverage covenants (maximum debt, maximum leverage, funded debt to tangible net worth, liabilities to tangible net worth, debt-to-EBITDA, debt to cash flow, employee loans, etc.)
  • Coverage & cash flow covenants (debt service coverage, EBIT to interest, fixed charge coverage, cash flow to debt service, EBT, EBITDA, net income, etc.)                                              

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Jack’s knowledge of the banking structure and processes has proven to be very beneficial to Canada Colors over the years in obtaining the credit facilities and fees structures that it currently enjoys today. I would not hesitate to recommend Genus Financial Corporation as a treasury consultant.

Canada Colors and Chemicals Limited
Brian R. Job
Vice-President, Finance